Bitcoins offer virtual wealth but very real risk

Never invest in a business you do not understand.

If something appears too good to be true, it probably is.

Those are two wise and important rules to live by, and if you follow both, you'll stay far, far away from cryptocurrencies like bitcoin, including the new bitcoin futures market.

This is a column I've tried to avoid because it takes time to understand blockchain technology and how immutable, distributed ledgers will eventually revolutionize commerce. Thanks to some basic cryptography classes from my Army days, I even understand how bitcoin is mined and its integrity is maintained.

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Bitcoins don't, however, void the basic laws of economics. Strings of computer code will never become a true currency capable of holding value over time. And just as gravity holds us to the Earth, economics will bring bitcoin's perceived value crashing down.

Proponents of cryptocurrencies love the fact that no government regulates or controls them. Bitcoins exist only as pieces of computer code stored on a ledger shared by thousands of servers around the world, and it only has value because those users say it does, not because a government guarantees it.

Unlike the dollar, which the Federal Reserve can print or take off the market as economic needs require, bitcoins are released at a standard rate per week. New bitcoins are awarded to the owners of the servers that maintain the ledger and perform difficult mathematical calculations, a process known as bitcoin mining. The bitcoin supply is determined by an algorithm.

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Anyone in the world, meanwhile, can spend real money to buy bitcoins and anonymously trade it with other owners of bitcoin without anyone tracing it. That's why bitcoins are popular among criminals, particularly extortionists, embezzlers and money launderers.

The value of bitcoins are determined solely by how much the owner of a bitcoin wants for it and how much a buyer is willing to pay. Prices vary widely based on which exchange is used, and most transactions take place in China, South Korea and Japan.

Some say bitcoins are the new gold, but you can't bury bitcoins in the backyard, and there are no industrial uses for it. Bitcoins only exist on the shared ledger, where hackers can and have stolen it.

Others have compared bitcoins to the tulip-bulb bubble of 1636. But that's unfair, because you can store bulbs in the backyard, and if they lose financial value, you can still enjoy the flowers in the spring.

However, if a government, such as China, bans bitcoins, or everyone wakes up tomorrow and decides it is a fad, then it becomes worthless instantly.

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There is no rational explanation for why a bitcoin traded at 6 cents in September 2010, reached $3,025 in June and hit $17,513 at noon on Tuesday, according to Coindesk.com. That's a lot for something that exists solely as a mathematical equation in a market that no single person or institution controls or regulates.

Traders also need to explain this: Why bitcoins and not one of the 800 other crypto-currencies that use the same technology? Why not litecoin, ethereum, crypterium, titcoin or potcoin?

Human greed and ignorance are the only explanations.

Remember the late 1980s, when everyone said real estate could only go up? That led to the savings and loan crisis and the 1991 recession.

Remember the late 1990s, when everyone said dot-coms could only go up? That led to the telecoms-led recession of 2001.

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Remember the late 2010s, when analysts said one bitcoin would hit $100,000 in 2018? That was this week, after an unknown number of people already had $285 billion invested.

No sane person can look at bitcoin's 1,600 percent price increase this year and deny that speculators have taken over something that was supposed to be an alternative to official currencies for international transactions. The only way 15 percent daily price gyrations happen is when investors are making huge bets and cashing in huge profits.

Some proponents believe the Chicago Board Options Exchange decision to start trading bitcoin futures this week marks bitcoin's entry into mainstream financial markets. The opposite it true.

The federal Commodity Futures Trading Commission regulates these markets, and CBOE, and beginning next week the Chicago Mercantile Exchange, must adhere to government oversight. Bitcoin exchanges that settle the futures contracts also will need to conform.

Widespread bitcoin adoption would also introduce unmitigated risk into global currency markets because you have to buy bitcoins with an existing currency. If central banks see bitcoins as a risk to the global economy, they will regulate it, shut it down or replace it.

South Korea's prime minister, a deputy governor of China's central bank, and regulatory officials from Japan and the U.S. all have warned investors and markets about crypto-currencies, signaling their anxiety over what happens if the bubble gets any bigger. Of course, if they step in, the bubble will definitely burst.

So are people making money from trading bitcoins? Absolutely. Do we know when the bubble will burst? No idea. Should you try to ride the wave before it crashes? See above.